Understanding the Funded Ratio

Everyone wants to know where they stand with their finances – Will I be able to have the retirement I want? Do I have enough? Roughly how far do I have to go? Am I overfunded (believe me, it happens)?

A funded ratio is a great tool for taking stock of your financial picture as it relates to the future and helping find answers to these questions. It gives a point in time analysis of how your assets compare to your future liabilities. In other words, will your money outlast your expenses. The ratio – your assets divided by your liabilities – can help guide you toward the retirement you want.

If your funded ratio is greater than 1 – meaning that the value of your assets is greater than the value of your liabilities – then you’re in great shape because, theoretically, you should be able to pay all of your liabilities. Depending on just how far above 1 you are, you might be able to spend more either now or in the future, as well as consider annuitizing more of your assets (either through actual annuities or bond ladders) to generate more reliable income and lock everything in.

If your funded ratio is less than 1, well, you have some work to do and need to think about how you make up the shortfall. You can look at increasing your savings rate or reducing your future spending. You will probably also need to take some investment risk to reach your retirement income goals.

While it’s easy to key in on that ratio of 1, it’s important to note that this is a broad spectrum. A funded ratio of 1.01 really isn’t all that different than 0.99. There are no bright line tests with a funded ratio, but it can help you understand how much risk you will need to take to reach your goals.

How Is the Funded Ratio Computed?

Conceptually, a funded ratio is really simple. You add up all of your assets. You add up all of your liabilities, and then divide your assets by your liabilities.

But there’s a catch (there’s always a catch). Not all of your assets and liabilities happen at the same time. We need to use what’s called a “present value.”

The idea behind present value is that a dollar today is worth more than a dollar tomorrow. If you were to loan me some money, even if you knew I would pay you back, you would still charge interest.

You need to be compensated for letting me use your money now. The amount you decide to charge me is called the “discount rate.”

Discount rates sound incredibly dull (and understandably are to most people), but they’re the most important decision you will make about your funded ratio. You want to use something that will account for the risk associated with your future cash flows (inflation and otherwise), as well as the long-term nature of your financial life.

There’s no “right” answer here. Choosing the appropriate discount rate is a judgment call, and often comes down to just how aggressive you want to be with your analysis.

To give you an idea of how this works, let’s say that I am going to receive $1,000 in two years, and I am using a discount rate of 5% (don’t read anything into this number – it just makes the math easy). To figure out the value of this cash flow to me today, we would discount it back using that discount rate. We’ll do this the long way first so that you can see the intuition.

The first thing that we would do is bring the payment in year 2 back to year 1, so we will discount it by one year – we’ll divide the payment amount by one plus the discount rate:

$1,000 / (1+ 0.05) = $952.38

So now we have the value of that payment one year in the future. To get the value today, we’ll do the exact same thing one more time:

$952.38 / (1 + 0.05) = $907.03

So that $1,000 payment in two years is worth $907.03 to me today. A quicker way of figuring this out is to use a little bit of algebra:

Present Value = Payment / (1 + Discount Rate)^Time

This is equation the heart of finance. When you boil everything down (and strip out the regulatory aspects) all of finance is trying to figure out one of the elements of that equation. Whatever complicated, crazy, convoluted thing the folks on Wall Street can come up with, it always boils down to this equation.

Deciding on the right discount rate is incredibly important. Using a higher discount rate means that cash flows out in the future (both spending and potential income) will be less important. A lower discount rate will mean that those future cash flows will have a bigger impact because they are discounted less.

It really comes down to what makes the most sense in your situation.

So let’s look at the different components.

Assets

Adding up your assets is generally pretty easy. There are three broad categories of assets you’ll want to think about when running a funded ratio analysis: Investments, Reserves and Real Assets, and Reliable Income.

Let’s walk through them in turn:

Investments

This is the easiest part of the whole analysis. Just add up your current account balances. We’re looking at everything in terms of present value, which means we don’t need to worry about what your future investment returns will look like.

Remember: one of the major purposes of the funded ratio is to figure out how much risk you need to take to reach your retirement goals. Including assumptions about investment returns above the discount rate would make that more difficult to tease out.

Reserves and Real Assets

This category is where you have to make some judgment calls. It includes anything with monetary value, but you may, or may not, want to include some things in your analysis.

Here are two big examples that people often struggle with:

1. Your home

If you’re like most people, your home is the most valuable financial asset you own. But including it in your retirement plans is a big decision. It makes sense if you’re planning on downsizing in retirement, but not everyone is.

Depending on your situation, your house is pretty illiquid (especially compared to your investments), and if you need to sell it now, you’ll probably get considerably less than what you could if you didn’t have that time constraint.

It’s also pretty all or nothing. You can’t sell one-third of your house. Selling your home because you’re $5,000 short is a pretty bitter pill to swallow. If you decide to include your home, just include however much equity it currently holds for you.

2. Inheritances

This is another difficult question. For some people, an inheritance can be a huge financial windfall, and a large part of how they fund their retirement.

But it’s hard to know for sure how much you will receive and when (or in some cases, if you will receive anything).

Just like everywhere else in retirement planning, you only want good surprises. When we have to estimate something (read “guess”), we always want to be conservative. That means you should make your best realistic guess about what you can reasonably expect to receive and when. Then plug in a smaller number further out for the analysis.

Reliable Income

Your reliable income is all about figuring out how much it’s worth today. Since you’re confident about how much you’ll get and when you’ll get it (it’s reliable income after all), we just need to translate those cash flows into today’s dollars.

Once you discount everything back to today, you can add up all of your assets. You now have half of your funded ratio. Now we need to calculate the other side: your liabilities.

Liabilities

Your liabilities are a little bit more complicated, but calculating the present value of your liabilities is just the flip side of calculating the present value of your assets. There are all sorts of ways to cut up your liabilities, but it comes down to trying to figure out how much you want to spend in retirement and smoothing out one big wrinkle: taxes.

Figuring out Your Expenses

The first step is deciding how much you want to spend in retirement. It’s tempting to simply throw down a big round number and call it a day, but you’d be short-changing yourself.

If you’re going to the trouble of determining your funded ratio you owe it to yourself to do it right. Think about what you actually want out of retirement. What do you want to do? And how much will that likely cost?

You don’t necessarily need to budget out exactly how much you’ll be spending on groceries when you’re 83, but you’ll want to make some reasonable estimates for each of your big spending categories. You’ll want to think about your:

• Day to day living expenses
• Vacations
• Mortgages and any other debt
• Charitable donations
• Health care expenses
• And anything else that you can think of

Once you’ve put all of that together, it’s worth going a step further and slicing it up a little bit.

• How much is truly essential?
• What is more discretionary or aspirational?
• What could you live without?

The goal is to have more than enough to comfortably cover everything. If by some chance you come up short, separating essential and discretionary expenses is immensely helpful. Your portfolio will likely look very different if you’re stretching to reach your discretionary goals versus struggling to cover your essential expenses.

Factoring in Taxes

A lot of people leave taxes out of the equation when computing their funded ratio. Calculating your tax burden thirty years in the future is hard. But it’s also incredibly important. How you saved your money makes a huge difference.

Imagine if you spent your whole life diligently saving everything in your traditional 401(k). When you go to spend that in retirement you’ll be taxed at ordinary income rates. On the other hand, if you’d been saving everything in a Roth IRA, your retirement income from your investment portfolio would be free and clear from taxes.

Taxes matter, and if you don’t include them in your analysis, you are missing out on a pretty massive piece of the picture.

Putting It All Together

Now that we have the present value of your assets and liabilities, we can compute your funded ratio. This is the easy part – just divide your assets by your liabilities.

Now You Know Your Funded Ratio…Now What?

Now what do you do with the number?

If your funded ratio is significantly above 1, then you are in great shape and can probably afford to take some risk off the table. If it’s significantly below 1, then you’re…not in so great shape, and will likely need to take on some more risk to reach your spending goals.

Your financial situation isn’t static – especially if a large amount of your retirement portfolio is allocated to your investment portfolio. As the markets move, your financial situation changes (hopefully for the better). Any financial planning that you do with your advisor should be revisited continually.

Your funded ratio isn’t going to give you all of the answers, but it will help you sort out what your retirement portfolio should look like to get you where you want to go.

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